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Exotic options

original version of the final published article in EPRM
Dec 2002 issue.

"That Option Called Power" by Anne Ku

As
a derivative of other fuels, electricity is an exotic option. Despite the current
downturn in energy trading activity, such complex options continue to be structured
and embedded in power contracts. Anne Ku surveys both sides of the Atlantic.

Power
is complex and exotic. By definition, anything other than a plain vanilla European
or American call or put option is exotic. Electric power is a compound option,
for energy from a power plant is an option on the capacity, which itself is an
option on the input fuels. A power plant is a spread option, for the plant is
profitable to run if the output power is more valuable than the input fuel and
operating costs.

"Everything in power is exotic," declares Chris
Strickland, Director of Lacima Group,
who is based in Sydney, Australia. Some typical examples include a capacity option
on a facility with path-dependent type characteristics, swing contracts, gas storage
and gas supply agreements, fuel supply contracts, and long-dated tolling agreements.

What makes such kinds of options exotic? Strickland points to numerous
assumptions about forward curves, volatility, and jump parameters in their valuation.
Douglas Coyne, Energy Consultant at The Oxford-Princeton
Programme, notes that many exotic options do not have valuation formulas and
must be priced through one of several estimation techniques.

One way to
initially identify and quantify the optionality found in power contracts and fixed
assets is to ask a series of questions (column panel).
Exotic options mentioned in this article are explained in greater detail in table
1.

Underlying transparencyThe popularity of an option depends
greatly on the availability of its underlying price or index. In the US, heat
rate options are sold to owners of power plants to hedge their plant output, effectively
spread options on a toll (gas and power prices). In Texas, super-peak options
were traded but liquidity for the product has diminished. Designed for retail
marketers or load-serving entities to shape load for their customers, this option
allows you to choose any 4 hours in the day you want, in the peak period of 16
hours. They are also good for owners of peaking plants which run for only 3 or
4 hours a day. Limited-strike summer daily options at PJM, which were popular
for a while, allow you to exercise 6 times within 23 days in a month.

Barry
Trayers, options trader at Tractebel USA,
Houston, Tx., sees financial options coming back only when a reliable and independent
index is produced. The demise of NYMEX electricity futures, recent controversy
over certain traders rigging Platts gas prices, and the shift back to voice brokering
and bilateral contracts all serve to dampen this price transparency. Without financials,
power options have high transaction costs related to the manpower involved in
scheduling physical delivery. People are expecting published indices to come out
of the formation of Regional Transmission Organisations (RTO). "Once you
get indices, options can get more exotic," he says.

Credit effect
on liquidityAs the larger energy trading firms get downgraded on credit
rating, finding credit worthy counterparties becomes harder. According to Shezad
Abedi, CEO, Bright Spark Energy Risk Consultancy, London, valuable structured
trades are often also longer term as well as more complex. He explains that the
industry structure is changing so rapidly in the underlying markets that counterparties
need margin to cover non-quantifiable or non-hedgeable risk.

Christophe
Chassard, VP, Head of Structured Products, RWE
Trading, London says that the biggest impact on their business has been the
departure of American energy merchants from Europe, leaving fewer counterparties
to trade with. "Most of the remaining (especially energy end users) have
been reluctant to enter into exotic transactions because they are less transparent,
more complicated to understand and/or value. However, as a group, RWE Trading
is prepared to do more exotic trades and has, indeed, experienced a noticeable
increase in the volume of exotic transactions it has entered into since the beginning
of the year."

While the better credit-rated banks may have picked up
some good people from energy trading, they still need the underlying physical
liquidity. E-lecTrade's president Anil
K. Suri sees energy transactions going back to the slow way of doing business,
via Request for Proposals (RFP) for the moment. The RFP process allows a case
by case arrangement of credit and removes the potential for round-trip trading.
As the market recovers, it would look for solutions that provide credit support
along with transparency, sort of a modified RFP process. Suri is sure that exotics
will stay, given the complexity of serving electricity as a commodity, but they
will be largely unhedgeable.

The way outThe drying up of liquidity
doesn't end the power business. Petros Fanis, senior options trader at EDF
Trading in London sees the current liquidity crisis a result of companies
that had over-expanded, got it wrong, and are now returning to their core business.
This boom and bust cycle has happened in other markets before.

Trading oil,
gas, coal, and power options, Fanis operates in several markets. Cross-commodity
options convert the risk of electricity into another commodity that is more suitable
and understandable for the customer. For example, an aluminium producer has an
electricity contract tied to the price of aluminium rather than power. Because
of the synergies between various commodities, you can apply the same pricing and
risk management philosophy across different commodities.

With less liquidity,
it is more difficult to hedge or lay off risk. Most merchant power assets have
lives of 20 plus years, but a majority of these assets are hedged for only the
first couple years. A liquid long-dated market doesn't exist. David Goodman, Director
of Power Trading for Entergy Koch Trading (EKT)
in Houston believes that companies which divest themselves of their trading and
marketing capability will still have this risk on their books. "When you
take on a physical asset, such as a power plant, you inherently have risk. Trading
allows you to hedge out near term risk, while origination (marketing) allows you
to hedge out the long term risk, which is less liquid."

Greater
awareness of riskLacima Group's Strickland observes that people became
more aware of their risks after Enron's collapse took away the liquidity of standard
products. "Companies, especially the smaller players in generation and retail
supply, are looking at the risks more closely now. End users are also looking
for more structured type trades as they are exposed to power prices and other
factors."

This greater awareness of risk has brought new business
to A3-rated EKT, whose exotic portfolio includes precipitation-dependent options,
weather-sensitive strike calls, and multiple strike options.

Exotic options
embedded in insurance products have also appeared on the scene. Swiss
Re's forced outage insurance (ELPRO - Electricity Price and Outage Solutions)
behaves like a contingent call option, as the payoff is above a strike price and
the call is available only if there is a forced outage or forced derating. ELPRO
protects generating units from the operational risks associated with the price
of electricity.

Exotic needs of end usersLiquidity of wholesale
power trading aside, end users of power have specific requirements and usage patterns
that standard tradable options cannot meet. For this reason, it is common for
exotic options to be embedded into most retail power transactions, without the
customer's awareness. Lance Hinrichs,
a Houston-based consultant summarises as follows.

Utilities often give discounts
to large customers for the right to interrupt service in periods of extreme prices.
Such call options on power prices can be physical, where the end user must curtail
consumption, or be financial, where the end user can continue their consumption
but must pay the hourly spot price. For many large consumers, the risk and inconvenience
of curtailment is well worth the savings.

Similarly, some end users are
able to "fuel switch" when it is economically advantageous. They switch
diesel or gas for electricity at facilities with on-site power generation capabilities.
Others have industrial processes that allow switching. Fuel switching is an option
on the spread between power and another source of fuel.

Third party power
marketers often exercise "rainbow" options in transitional markets by
annually choosing to physically serve or financially serve their long-term customers.
To physically serve their customer, they schedule customer load, procure wholesale
power and transmit to a utility distribution company. To financially serve, they
get service through the utility and pay for the service on customer's behalf.

Exotic assetsWhereas sellers of retail power contracts face
volume risk, owners of generation assets face price risk. This is the main difference
between the way load contracts are priced and the way generation assets are valued.
Increasingly, assets are valued using option pricing theory, in what's known as
the "real option approach". For example, a gas turbine unit with almost
instantaneous response to market signals can be treated as a portfolio of daily
spark (spread) options, with some caveats.

Victor
Belyaev, Quantitative Analyst at PG&E National Energy Group, Bethesda,
Md. explains that a power plant's flexibility affects its option value. Although
combined cycle units are more efficient than peakers, their slower response to
market signals means that they should be modeled as options with continuous daily
path-dependent payoff. Plant features that reduce their option value include minimum
up and down times, contractual restrictions, and limits imposed on the total number
of starts. Features that increase option value include fuel switching capability
(rainbow optionality), duct firing capability, and ability to sell power into
different pools in the absence of transmission constraints.

Raison d'etreExotic
options in power are not used for speculation, in contrast to those in foreign
exchange and equity markets, says Carlos Blanco, VP at FEA,
Berkeley, Ca. "Exotic options, when properly structured, hedged, and understood,
provide power market participants with a potent tool in their arsenal, giving
them the flexibility to manage and transfer inherent business risks to other parties
with natural offsets or different degrees of risk tolerance."

"Nobody
thought thoroughly about how to manage risk along the supply chain of a vertically
disintegrated electricity industry," observes Shmuel Oren, Professor of Operations
Research at UC Berkeley,
whose research work has been motivated by options in contracts, such as interruptibility
of service. "The way to do it is through a variety of financial instruments
tailored to specific hedging needs. A forward contract, for example, is not a
good hedge for a generator selling its power output. A better hedge is selling
a spark spread put option, which accounts for the generator's 'real option' of
shutting down when it is not economical."

E-lecTrade's Suri agrees
that such structures are sorely needed. However, he cautions that the high volatility
of electricity may not be hedgeable just by financial instruments or even physical
instruments if the underlying design of the power supply chain is flawed. "The
supply chain of risk has to mirror the physical reality of electricity supply.
End users vary their electricity usage at will, and that variable usage shock
is felt all the way back at the generating station. Unless the industry finds
a way to rationalise that risk in a deregulated environment, history will repeat
itself, leading to more financial losses. Over the next few years, innovativedeal
structures will surface to rationally price and allocate the unique risk of power
supply. That just means there are even more exotics to come."